Once you start pulling that pesky string next thing you know the whole sweater is undone.

— Weezer

As a quasi follow up to the tether piece written a few months ago, let’s go deeper, much deeper, into black abyss that is the heart of the financial system. IF successful we will have glued together the concept of rehypothecation with the concept of file sharing as erosion of ownership and ultimately fair participation in the digital economy.

The House

Imagine you own a home, then decide to sell it to Alice. Alice’s title company wires you 200,000 USD through her down payment + bank mortgage, then the real estate ledger at the courthouse gets updated.

Now imagine, you are not satisfied with only 200,000 dollars, why not sell the same house again to Bob? If any intermediary in the chain (metaphorical not actual) is duplicitous/incompetent this is very possible. Why?

Because there is no master ledger checking for duplicates and settling unique assets in real time.

Of course your master plan would unravel when Alice and Bob both attempt to claim ownership. Both moving trucks awkwardly arriving at the same time makes for dark comedy. Good thing you just boarded your one way flight to a sunny tropical island with no extradition relationship with the US.

The Music

Now imagine Alice clicks to play the latest Weezer song on Spotify. As she bops along to the crooning of River’s Cuomo, is Bob in any way harmed by Alice listening to the song?

Actually no directly but yes indirectly. Not to get bogged down in a very complex argument, but indeed the endless copying of the same underlying asset does have long term harmful outcomes. If you are curious how the middle classes get hollowed out when ownership is undermined, much of our arguments in the blog and book are informed by the works of Jaron Lanier, specifically his 2013 book Who Owns the Future?.

Put simply, copying the same underlying asset over and over again dilutes each copy. In the real world this is easier to spot as two family’s would find themselves fighting over the same physical real estate. In fugazi internet legacy finance land, the slight of hand is just tricky enough most people are fooled into thinking somehow a song is different than a house.

The Settle Up

Let’s break down the dirtiest word in finance: Rehypothecation.

Re: as in copying something over and over again

Hypothecation: As fancy banker speak for pledging assets as collateral

Here’s how it works.

What if the two (or 2000) simultaneous owners of the same house never had to see each other?

While legally there is one owner to the property, if they have a mortgage potentially many financial institutions can claim ownership on the same asset!

Pre-2008 it was the wild west at a staggering 4:1 claims on all assets vs actual assets like treasury bonds, mortgages, etc.

The IMF ’s Manmohan Singh is the foremost expert on collateral chains. Singh has recommended that regulators’ financial stability assessments be adjusted to back out “pledged collateral, or the associated reuse of such assets,” but policymakers have not heeded his wise advice. 

— Excerpt from Two Wall Street Terms Every Bitcoin Trader Needs To Learn Now

After sobering up from the financial crisis SEC rule 15c3-3 was adopted quasi limiting these shenanigans to 140% collateral to loan amount. This is why some people call this practice HIDDEN LEVERAGE. E.g. Ledger A can legally hold up to 140% of actual underlining assets and it is perfectly legal. Even today Singh estimates each actual asset is claimed by roughly 2.8 institutions.

old books never match

Imagine the entire global economy as a series of IOUs. IOUs are literally why we have the modern world, groups of people doing long term planning together to accomplish audacious things like building skyscrapers and rail roads.

What rehypothecation does is shadow duplicate the IOUs of every railroad and skyscraper, or more accurately the equity and debt that creates railroads and skyscrapers.

What if Warren Buffet’s tide goes out and some people indeed do not have pants on? As in several banks claim the same assets until a crisis happens and all of the debts trigger to actually settle up.

Such a doomsday scenario seems a little silly though not impossible. You can always solve the problem by printing more money to hose the taxpayer, mass dilute equity holders, or god forbid let over leveraged institutions fail.

On a more everyday level what about simple brokerage account trades or even wire transfers?

Again, the books will NEVER perfectly real time match. They can’t match unless all parties are using a natively distributed ledger system.

Thus, rehypothecation goes much deeper than mortgages. If bank A sends a 200,000 dollar wire transfer to bank B, for two days the money has magically been duplicated. Both bank A and bank B can claim ownership of the same asset until the settlement period closes.

Now imagine trying to do this for mega transactions like cashing out early employees after a major acquisition. If you need to wire 200,000 dollars that’s one thing. But 200,000,000 is entirely another matter.

To source so much liquidity (cash) you’ll need to source from many different providers, each with the ever present risk of defaulting during the settlement period.

Real time tamper proof settlement

A tidal wave development in the distributed ledger world came with the ability to easily issue tokens on top of an underlying protocol. Ethereum, Waves, Stellar, etc are great because you don’t have to reinvent the wheel each time. Some platforms like Waves are so easy you can create a provably unique token with built in decentralized exchange in less than a minute.

If your token represents equity, debt, real estate, cash, or anything that can be legally tied to the real world, you can settle up in nearly real time with no possibility of rehypothecation. Mathematically two wallets cannot hold the same tokens at the same time.

Put another way. If Alice bought 100 tokens representing 100% ownership in the house, it is impossible to sell the same tokens to Bob as the shared ledger would not match and thus not allow the transaction. On the music front, if Weezer pressed 5,000 album tokens that could only be unlocked by the token holder, music is now a scarce unique digital asset that might appreciate or depreciate just like any other asset.

This native tokenization provides immense benefits as long as you can safely manage your private keys.

Alas, the great Satoshi is a vengeful old testament style god. There are no do overs, and one mistake is the end of your ownership of the asset. Do we cosign with multi-signature trusted holders of our keys? It depends if you prefer burying silver in your backyard or in a safety deposit box.

Takeaways

So what does all of this semi-incoherent rambling have to do with your everyday investing life?

First (but less earth shattering) BE SUPER CAREFUL WHO HOLDS YOUR KEYS

As in a Bitcoin ETF in the traditional sense is probably a bad idea unless they can show a public audit to the world such as signing an address everyone can see that shows the address has the required collateral. Preferably in near real time, but at minimum once a day to prove the ETF net asset value = bitcoin collateral.

As in fiat gateways into crypto will always be compromised, or at least involve serious trust in the exchange as an onboarder of capital. Until the payment clears and the tokens are in your own private key wallet, there is always the chance for rehypothecation, commingling, or other legacy financial tricks.

Forget simple fiat transfers, 10 years on from the financial crisis can a single high frequency mortgage repackager prove they alone own your mortgage? Not just to an opaque SEC auditor, but real time to the public via a simple blockchain explorer UI.

Which brings us to the second and final (very earth shattering) statement:

Even if they had the entire system automated, you still need to trust the legitimacy of their centralized databases that can be unilaterally modified at any time without your consent.

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Thank you to Caitlin Long over at Forbes for starting to piece together the rehypothecation puzzle, and Jaron Lanier for popularizing the notion that ordinary people must capture some value back from the data they provide to prevent a descent into digital feudalism.